Hey guys - in the middle of a mental exercise that I can't figure out. I always thought that if cap rate was above your interest rate, then the debt was accretive to your cash on cash (CoC). However, I keep running into this deal that this is not the case. I tried to attach an excel but could not find an option to. Thank you for the help!
Purchase Price - $64M
Other Closing Costs and Reserves - $2,348,823
Total Uses - $66,374,750
Debt - 39.5M
Implies Equity of $26,847,750
NOI - $3.89M
I/R - 5.9%, assume IO ($2,330,500 of interest annually assuming 30/360)
Ignore cap-ex, recurring reserves.
My levered CF is $1.56M and implies my CoC is 5.8%. My cap rate is 6.07%. What am I missing here or am I just wrong that CoC should not be higher? If I include recurring reserves or any cap-ex my CoC gets way worse.
Interesting topic and curious to hear others thoughts. Do different LTVs change the math?
Well you have actually outlined the answer to your question quite nicely. Since you have several million of closing costs, fees and reserves, this compressed your yield-on-cost (YOC = NOI / purchase price + fees/costs) below your debt interest rate. This project has a 5.87% YOC which is less than your debt rate so you actually have negative leverage. It’s easy to just look at a cap rate from a high-level perspective but YOC is the actual, accurate metric you want to look at as a buyer as you will always have closing costs, fees, and capex/reserves.
Since this is a larger transaction, I am assuming most of this is due to the cash drag of the reserves which these days might actually be generating some income during the life of the deal so you could pencil a 3-4% interest gen expense from your money market account and that might get you closer to even leverage.
This. YOC > interest rate = positive leverage.
Ahhh, thank you. That makes complete sense - totally blanked on that. You’ve got the acq fee and rate buy down which are majority of the closing costs and both large.
What about interest rate unlev IRR?
Apologize as this is probably a dumb question - couldn’t you have an interest rate % greater than your YOC and still have the deal being accretive? For example, if you buy a property for $100, 60% debt 40% equity, NOI of 6 and interest rate of 8%. In this scenario, wouldn’t your interest expensive be $4.80 (60 x .08) and with an NOI of $6, you still net out 1.2, making your total return technically still positive? Maybe I’m over complicating a simple item or just missing something completely?
Technically, your YOC (6%) is less than your interest rate (8%) but it’s still accretive/positive leverage, no?
If the noi is 6% and your CoC is reduced to 3%, how is this accretive?
If you include the closing costs the actual entry yield is lower than the cost of debt
You are correct that if the interest rate is less than your cap rate, the debt is accretive. However, you are using the wrong cap rate--you should actually be looking at the total cost, or $66.3M. You must pay the $66.3M in order to earn the $3.89M of NOI, resulting in a 5.86% cap rate.
So if the interest rate is higher than 5.86%, the debt will be dilutive, and vice-versa. In this situation, if you decrease your interest rate by 30bps (to 5.6%), your CoC goes up to 6.25%, and if you increase the interest rate by 30 bps (to 6.2%), your CoC goes down to 5.37%.
Your example is interest-only, so this doesn't apply, but I run into a lot of dead ends with brokers where they talk about "positive leverage" but don't factor in amortization. If you are looking at a building where you max out at 25 years amortization, that is a significant increase in your borrowing costs. I know that you can twist yourself into a knot and say that amortization is paying down principal so it's not a cost, but it has a very large effect on your current yield (which is what a lot of investors look for). Plus there's an opportunity cost / time value of money angle as well.
Someone already said this, but it's not Cap Rate vs. Interest Rate - it's about ROC vs. Interest Rate.
This deal has a Return on Cost of 5.86% (including closing costs) vs. Interest Rate of 5.90%, that's why your Cash on Cash is roughly 5.81%, lower than the ROC and lower than the cap rate of 6.08%
If you didn't have any closing costs, your CoC would be 6.37%
This has been covered already but every other post is only addressing one factor instead of both.
1. At a high level, this should be your ROC vs interest rate and not cap rate. ROC > interest rate SHOULD be positive leverage, but is not always.
2. Building on "is not always", what really matters is your debt constant and not interest rate.
Bingo
In what scenario would it not be positive leverage given than the ROC > interest rate?
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